Arm’s length principle and the virus: Transfer pricing arrangements in times of Covid-19

published on 28 February 2020 | reading time approx. 2,5 minutes

In December 2019, the novel corona-virus broke out in Wuhan city, Hubei province, China and spread to the whole country, resulting in quarantine, postponed work resumption, logistics stagnation, and restrictions on import of Chinese commodity by some countries, etc.

As China is an important production base and consumer market of multinational groups in the world, the novel coronavirus epidemic will have a significant impact on the supply chain of multinational groups. Although the related impacts may gradually decrease as the epidemic slows down, it is expected that the epidemic will have a negative impact on the operating income of most multinational groups and impose a significant burden on the cash flow of their subsidiaries in China in the short term. Therefore, during this special period, multinational groups may consider to adopt certain reasonable arrangements or carry out some additional examinations for related party transactions.

Loss analysis and preparation of documentations

From transfer pricing perspective, even if the most appropriate transfer pricing method is adopted, the novel coronavirus epidemic could still temporarily result in the normal returns of group entities that are not consistent with their functional risk profile, especially for multinational groups that have established routine-function subsidiaries in China. According to the Chinese TP regulations, Chinese subsidiaries performing routine functions should obtain stable returns consistent with their functions performed, risks assumed and assets employed. Such companies would very likely be challenged by Chinese tax authorities if they suffer from losses or thin profitability.

In this case, groups would generally consider to make transfer pricing adjustments to ensure that entities with routine functions in the value chain could receive reasonable profits, while the principal could obtain residual profits (losses). Nevertheless, it should be further discussed whether the losses of Chinese subsidiaries with routine functions, which are generated due to insufficient productivity and slack market demand resulting from the epidemic as force majeure, should be borne by the principal which performs key functions and bears major economic risks in the value chain. In order to mitigate the potential transfer pricing risks for all parties, it is recommended to distinguish the losses caused at different stages (e.g. during the epidemic period and during the recovery period after the epidemic) and to prepare corresponding documentations to explain which party should bear the losses or quantify the losses caused by the epidemic.

Financial support

In addition, Chinese subsidiaries could encounter difficulties in cash flows due to the impact of the epidemic. In order to avoid cash flow break, it is recommended that groups should actively communicate with all parties and have an accurate understanding of market fluctuations as well as changes in supply, dynamically assesse the cash flow of Chinese subsidiaries and provide various supports in a timely manner:

INTRA-GROUP FINANCING, INCLUDING THE GRANTING OF LOANS BY THIRD-PARTY FINANCIAL INSTITUTIONS WITH A GUARANTEE SUPPORT

Intra-group financing is probably the most direct form of financing support. However, groups have to consider not only the issues such as interest rates, tax burdens and foreign debt ratios, but also thin capitalization in case of intra-group financing. Interests actually paid by the enterprise to its related parties that exceed the stipulated debt-equity ratios (5:1 for financial enterprises and 2:1 for other enterprises) shall not be allowed to be deducted for the current period or in the following years, unless the enterprise can provide relevant information and prove that relevant transactions comply with the arm's length principle. It should be noted that the guarantee fees paid to related parties for loans borrowed from third party financial institutions are also subject to the above mentioned restriction on debt equity ratio, if the loans are guaranteed by related parties.

LOSS COMPENSATION

As mentioned above, the loss compensation is also an option to support the cash flow of the Chinese subsidiaries performing routine functions. However, groups have to carefully analyze the proper approach for the compensation and prepare the relevant documentations to ensure that the compensation is deductible before tax at the level of the principal and VAT could be reduced at the level of the Chinese subsidiary in order to achieve group tax optimization. Meanwhile, relevant contracts and documents are also recommended to be communicated with the bank and the State Administration of Foreign Exchange (“SAFE”) in advance to ensure the smooth settlement of relevant compensation.

ADJUSTMENT OF TRANSFER PRICING METHODS FOR RELATED PARTY TRANSACTIONS AND EXTENSION OF THE PAYMENT TERMS

From the long term perspective, adjustments of transfer pricing methods for related party transactions and the extension of payment terms during the epidemic-impacted period would also help to alleviate the pressure on the cash flow of Chinese subsidiaries. However, it is also recommended to prepare sufficient documentations to meet potential challenges from tax and customs authorities of all countries.

While Chinese entities are actively fighting the epidemic and preparing to return to work, they should also focus on financial and tax issues, follow up policies and take measures to reduce the tax burden. Multinational groups are advised to carry out active internal communications and start to prepare corresponding documents to support the reasonableness of the profit (loss) allocation to each party during the epidemic. Furthermore, the turning point of the epidemic is still unclear, for the potential cash flow problem, groups should also predict the situation and consider various methods to support the cash flow of the Chinese subsidiaries in a timely and effective manner.